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Don't Get Comfortable With Cheap Oil

Still-untamed speculation means it can snap back at any time.

If you live in the Northeastern United States, chances are you probably heat your home with heating oil. And if you've been paying attention to the recent decline in oil prices, then you're probably thinking, or hoping, that your heating bill will be coming down this winter.

Don't bet on it.

Despite record heating-oil stockpiles, the price may actually rise this winter, rather than falling as the laws of supply and demand would seem to dictate. If that happens, I suggest you direct your displeasure not at the oil companies (who so often receive the brunt of the criticism), but at Wall Street and investment banks like Morgan Stanley. According to oil-industry sources, Morgan is now the largest holder of physical heating oil in New England. While that may seem harmless enough, don't expect to see tanker trucks with the Morgan Stanley logo pulling up to your house to top off your heating-oil tank any time soon.

Speculating on oil pricesIf anything, it's precisely the opposite. Morgan has gotten into the heating-oil game because there's money to be made on a pricing aberration that currently exists in the marketplace. This aberration -- where futures prices sell for more than the spot price -- developed as a result of all the wild speculation over the past two years.

Essentially, Morgan, or any other speculator for that matter, can buy a physical cargo of heating oil with a New York harbor delivery, then put it in storage and simultaneously sell a futures contract six months or one year out, locking in a risk-free rate of return plus some additional "alpha" (percent gain), even after all storage costs are considered.

Moreover, investment banks like Morgan, being the highly experienced traders that they are, have the ability to marshal enormous leverage when it comes to making these trades. That gives them as much clout as major oil companies, even if their balance sheets aren't as big.

Sean Cota is the president and co-owner of Cota & Cota Oil, a Vermont-based heating oil distributor. He also serves as president of the New England Fuel Institute, and he's the Northeast president for the Petroleum Marketers Association. Cota says that Morgan Stanley is by far the biggest player in the heating-oil market in New England.

Can you dance the contango?While this may seem innocuous, it actually isn't. Warren Mosler, chief economist and founder of Valence Corp. (a large hedge fund), explains: "The physical oil held by Morgan Stanley is largely spoken for and will not be burned, due to it being the offset to derivative positions. Moreover, other investment banks and traders may be doing the same thing, meaning that whatever is left over as free, usable oil will have to be bid for, thereby driving up the price." He adds, "This will continue until the market 'backwardates,' meaning that spot prices will have to climb above futures prices. This will eliminate the financial reward for storing oil and selling forward."

The above explanation ties in to the speculation argument and the impact it's having on oil prices. You may recall my article a couple of months ago, in which I examined this in detail. I specifically mentioned the report released by the Senate's Permanent Subcommittee on Investigations last June, which stated unequivocally that speculation was a key factor in high oil prices. Coincidentally, the report also named Brian Hunter, the former chief energy trader for the failed hedge fund Amaranth, as being one of the biggest players in the natural gas market. That report was released prior to the collapse of the fund, which you probably know resulted from the massive losses Mr. Hunter incurred in the natural gas market.

In the past two months, petroleum prices have fallen substantially. However, the markets continue to exhibit a positive carry, or "contango" (futures prices higher than spot price). Ultimately, this is a bullish situation, meaning that even slightly higher-than-expected demand could drive prices right back up again (a colder-than-expected winter, for example).

In the big picture, hedge funds have been only partially to blame. While there's no doubt they've been big buyers of commodities in the past few years, recent selling and liquidation from major funds like Amaranth have also helped to push prices down, so it can work both ways.

Of far more import, perhaps, is the money coming from large, long-only institutional investors like pension funds, college endowments, and the like. They have poured tens of billions of dollars into commodities. They buy and hold for the long term. Once again, this represents a "claim" on physical oil (or any other commodity), either directly or indirectly. (In the latter case, investors buy an indexed instrument, but the counterparty that sells the instrument hedges by buying oil or some other underlying commodity.)

One example of a large institutional investor that has been active in commodities is the Harvard endowment, which at $30 billion is the biggest of any university endowment. Its chief portfolio manager, Mohamed El-Erian, said that the fund would increase its exposure to commodities, even after the last several years' good run. A similar decision was recently made by the Yale endowment, which at $19 billion is the second largest.

Same old, same old?These decisions can be expected to continue until investment returns for commodities no longer justify making the commitment. Perhaps that's starting to play out now, but before these giants and others like them decide to change strategies, the markets will have to make major moves. That means oil will have to fall and stay low for a fairly long period.

In the meantime, expect price distortion to linger, and the potential for sharp rallies in oil during the coming winter to remain high.